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Executives

Dean Cantrell - Director of Investor Relations

T. M. (Tim) Solso - Chairman and Chief Executive Officer

Tom Linebarger - President and Chief Operating Officer

Patrick (Pat) J. Ward - Vice President and Chief Financial Officer

Analysts

Meredith Taylor - Barclays Capital

Chip Miller - JPMorgan

Stephen E. Volkmann - Jefferies & Company

Analyst for Jamie Cook - Credit Suisse - North America

[Jerry Ravich] - Goldman Sachs

Andy Casey - Wells Fargo Securities

Charlie Rentschler - Wall Street Access

Joel Tiss - Buckingham Research

Henry Kirn - UBS

Ben Elias - Sterne, Agee & Leach

Cummins, Inc. (CMI) Q2 2009 Earnings Call July 30, 2009 10:00 AM ET

Operator

Good day ladies and gentlemen and welcome to the second quarter 2009 Cummins earnings conference call. My name is Fab and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator's instruction) As a reminder, this conference is being recorded for replay purposes.

I will now like to turn the presentation over to your host for today's call, Mr. Dean Cantrell, Director of Investor Relations. Please proceed.

Dean Cantrell

Thank you, Fab. Welcome everyone to our teleconference today to discuss Cummins' results for the second quarter of 2009.

Participating with me today are Chairman and Chief Executive Officer, Tim Solso; our President and Chief Operating Officer, Tom Linebarger and our Chief Financial Officer, Pat Ward. We will all be available for your questions at the end of the teleconference.

This teleconference will include certain forward-looking information. Any forward-looking statement involves risk and uncertainty. The Company's future results may be affected by changes in general economic conditions and by the actions of customers and competitors. Actual outcomes may differ materially from what is expressed in any forward-looking statement. A more complete disclosure about forward-looking statements begins on page three of our 2008 Form 10-K and it applies to this teleconference.

During the course of this call, we will be discussing certain non-GAAP financial measures and we refer you to our website for the reconciliation of those measures to GAAP financial measures.

Our press release with a copy of the financial statements and a copy of today's webcast presentation is available on our website at www.cummins.com under the heading of Investors and Media.

Before we review our second quarter performance and updated guidance for 2009, I would like Tim to say a few words.

T. M. (Tim) Solso

Good morning. Given the challenging economic conditions in which we are operating today, I was pleased with our performance in the second quarter. The actions we have been taking to keep the Company strong during the recession have made a difference which you can see in the improved profitability and cash flow from the first to second quarter. Tom Linebarger will provide more detail on our actions in the second quarter but I wanted to begin by highlighting a number of positives from the quarter.

Excluding restructuring charges, our EBIT performance has improved each of the last two quarters. In the fourth quarter of 2008, EBIT was 2.8% of sales. In the first quarter, it was 3.9% of sales and in the second quarter, in increased to 4.8% of sales. This improvement is the result of the aggressive action we have taken to control cost during the downturn. We generated nearly $240 million in cash during the quarter as the result of inventory reduction.

Our cash position improved significantly during the quarter and we have not borrowed from our $1.1 billion credit revolver established last year. We increased market share in several markets including the North American heavy duty truck engine market where our year-to-date share is now above 46% in which you had 50% in May and our distribution business had an extremely strong quarter given the current economic situation.

Looking to the second half of this year, our goals remain the same as they have been for the past several months. We will continue to focus on generating cash so we can invest in critical technologies in products for 2010 and beyond and we will keep a tight running cost and closely monitor manufacturing capacity to align with the real demand for our products. As I have said before, we remain confident that the Company is well positioned to take advantage of a number of long term market trends and will resume its growth once the recession end.

We are performing far better in this recession versus past downturns, even though this is the worst economic climate since World War II and we continue to explore profitable growth opportunities so we can build on our fundamental strengths when our markets recover. Having said that, I want to remind everyone that the global economy remains weak. While we seen modest improvement in some markets such as China and India, we are continuing to manage the business under the assumption that we will not see a meaningful recovery in our markets until at least late 2010.

Given our outlook on the economy and end markets for the remainder of the year, we are maintaining the sales and EBIT guidance for 2009 that we shared with you at the end of the first quarter. We expect sales to be slightly more than 30% lower than 2008 and EBIT of 5% of sales excluding restructuring charges. Finally, I would like to say a few words about our preparation for the 2010 product launch.

We remain on track for the largest product launch in our history in 2010 and so far, our fuel test results have exceeded expectations. As a reminder, we are introducing four new engine platforms and several new components in the next 12 months. We have tested our 2010 heavy duty truck engines with approximately 50 major customers and just as we have in the last several years, we have run the engines in all weather conditions and across all duty cycles. We have tested the engine in minus 40 degree temperatures in Yellow Night, Canada and in the 120 heat of Death Valley, California and the results have shown great performance, solid reliability and improved fuel economy.

By the beginning of the fourth quarter, we expect to receive EPA certifications on all our engines and by the time we go in the production in January 2010, our new heavy duty and mid range engines would have had approximately 5 million test miles. Just as we did in 2002 and in 2007, Cummins will live up to its commitment to produce the cleanest diesel engines in the world on time and with the reliability, fuel economy and performance our customers have come to expect.

Now, Tom will share some additional details on the second quarter and why we think the Company continues to be well positioned for the future.

Tom Linebarger

Thank you, Tim. I would like to start by quickly echoing two of Tim's themes, our expectations for the economy and our markets for the rest of this year and through 2010 remain the same. We are seeing modest improvement in our business in China, India and Brazil in times with the recession is found out in each part of the world but it is far too early to say the global recovery is underway. We feel good about our position not only as it relates to our abilities to remain profitable and generate cash through the downturn, but also to our ability to emerge in recession stronger than ever.

In terms of our major geographic markets, we have seen no improvement in North America and Europe with the latest economic forecast call for no real growth for the rest of this year. The situation is somewhat better in our key emerging market of China, India and Brazil.

In China, domestic demand is relatively strong and improving while the export market remains very weak. Gross domestic product for the first half of the year is forecasted to be 7% while the second quarter growth accelerating to nearly 8%. We are seeing increased order rates in China in line with the strengthening economy. In India, the situation is similar with domestic demand expected to grow and exports to remain relatively weak. The Indian government has projected a 7% GDP growth for its current fiscal year which ends in March 2010 with a recovery expected in second half.

From an end market perspective, the biggest change from the first quarter came in rapid volume decline in the late cycle market such as mining, oil and gas, and power generation. Our power generation sales for example were down 35% from a year ago and are now expected to be down 30% to 35% for the year. We began implementing cost reduction actions immediately as the downturn started and as Tim mentioned, our performance improved from the fourth quarter of 2008 as our cost reduction efforts began to take hold.

For example, our selling, administrative and research expenses fell $19 million from the first quarter and are down $108 million from the same period in 2008. We also continued to reduce or reorganize manufacturing capacity in response to the volume declines. Our action since the fourth quarter of 2008 scale back the Company's manufacturing operations resulted in $13 million in reduced spending compared to the first quarter and $43 million since the second quarter of 2008.

Our capital spending in the second quarter was $75 million, 32% lower than the same period in 2008 and for the first half of the year, we have spent a $939 million on capital projects with 31% less and during the six months of 2008. While we are working hard to lower our cost during the downturn, we are still finding ways to make the Company stronger for the long run. We are continuing to fund critical and time-sensitive projects since those linked to 2010 product launches and research and development on fuel economy improvement.

Even with the reductions we have made, capital spending in 2009 will represent the third largest total in our history. We also launched the first of our four new engine platforms in June, the ISF 3.8 engine went into production, our Foton-Cummins joint venture in China, the next platform, the ISF 2.8 is expected to start production at the end of this year. We continued to provide world class service and support to our customers across all four business segments. We are investing in new ways to demonstrate that we care about our customers' success even in the toughest time.

We have taken advantage of the volume slowdown to improve processes and synchronize flows through a number of plants and distribution centers so that when demand does return, we will be ready to ramp up as quickly as possible. We have moved swiftly, both within individual businesses and working across our business unit to solve inventory and supply chain problems. These efforts have led to a significant improvement in our inventory position.

As you know, we have reduced our workforce significantly in the past several months. Our employees have responded to this challenge by working together more effectively than ever. The increase productivity we are seeing is one of the primary reasons we have responded to this recession more effectively than in previous downturns. Pat will talk about our business segments in a moment but I want to close with a few words on or relationship with Chrysler.

As you know, Chrysler merged from bankruptcy protection in June. As part of its plan to contracts with the Dodge Ram Heavy Duty Pick Up Truck were assigned to the new Chrysler and while those associated with our light duty diesel program were not. Both of these results were as we expected. Production of the 6.7 liter turbo diesel engine for the Ram have resumed temporarily at our Columbus mid range engine plant to fulfill the remaining demand for 2009. We expect to return to work on a more permanent basis when Chrysler begins production of the 2010 model year trucks this fall.

We were actively seeking additional customers for our light duty engine even as we continue to discuss a new arrangement with Chrysler. Although the recession has delayed our plans to begin light duty engine production in US, we remained convinced that this market has significant potential for Cummins. We have a lot of work ahead of us but I am confident that we have the plans and the people in place to manage through the global recession and emerge in even stronger company.

Now I will turn it over to Pat who will provide more details about the second quarter.

Patrick (Pat) J. Ward

Thank you, Tom. Cummins delivered the solid financial performance this quarter considering the challenging market conditions we continue to face. We remain on track to meet our 2009 guidance of achieving 5% EBIT margins before restructuring and generating positive cash flow.

Second quarter sales were down 37%, a drop of almost $1.5 billion from a year ago, which contributed to a decrease in gross margins of $431 million. This was partially offset by spending reductions in selling, administration and research and development of $108 million. EBIT margins drop from 12.1% last year to 4.8% this quarter excluding the $7 million of restructuring charge.

Compared to the first quarter, sales were slightly down. However, EBIT margins excluding restructuring charges included from 3.9% to 4.3% as a result of a cost reduction actions with stronger joint venture income in the emerging markets. Earnings per share were $0.30 this quarter excluding the restructuring charges.

Let me provide more detail in the performance of each of our segments as well as our full year expectations. In order to make the comparisons more meaningful at some of our volumes, I will also highlight the sequential [vering's] analysis.

Distribution revenues highlighted in slide seven were down 20% from a year ago with 9% of the drop due to currency but were up 12% versus the first quarter. Profitability remained strong at 11.9% of sales which is above the segments target profitability levels. For the year, we are maintaining our previous revenue guidance of down 15% to 20% of distribution and playing at the second half will be slightly up from the first half of the year in sales mainly due to seasonality.

Given the year-to-date performance of the segment, we are increasing our EBIT margin expectations to 12% of sales in 2009. We are pleased with the performance of the distribution segment in this downturn which shows our diversification efforts that we are doing on.

In the engine segment, revenues dropped 45% versus the same quarter a year ago driving segment profitability to nearly breakeven. Compared to the first quarter of 2009, revenues dropped to further 12% to almost $200 million due to the Chrysler shutdown and a short reduction in demand for high horse power engines. However, despite the lower revenues, segment profitability improved sequentially over the first quarter as a result of continued cost reduction and stronger joint venture earnings in the emerging markets.

We are maintaining our previous full year guidance for revenues going 30% to 35% and EBIT margins between 1% to 1.5% of sales for the engine segment. You can find more details about our outlook for the engine markets on slide 11 of our presentation. We are forecasting not the classic heavy duty truck production of 98,000 units in 2009 and the market share for the year at 47% or 2% each points up from 2008.

From medium duty truck, we expect our shipments to drop over 20% in Brazil, more than 30% in North America and close to 60% in Europe. We are forecasting revenues to be up 20% for bus due to stimulus packages especially in North America and in India and for industrial engines, revenues will be down more than 40% with all markets affected by the global slowdown and channel inventory collections.

Our guidance implies a slight increase in revenues from the first half to the second half of the year for engines mainly due to the higher demand from truck and bus applications in North America and some stabilization and global construction markets following inventory collections. We also expect profitability to improve sequentially in the second half of the year from slightly higher volumes, stronger joint venture income in the emerging markets, more commodity cost as well as the impact of the restructuring actions we have taken over the past six months.

For the component segment, revenues in the second quarter also declined significantly by 41% from a year ago and were 5% lower than the previous quarter. The short fall off in the demand cause profitability to drop to a negative 2% of sales which is well below the rate of 9% that we reported last year and was in the previous quarter results.

For the full year, we are maintaining our previous guidance of revenue down 30% to 35% and EBIT in the range of 1% to 2% of sales. We expect to see a slight improvement in revenue from the first to the second half of the year mainly from North America and Chinese on highway demand. Profitability for the segment will improve sequentially in the second half of the year as a result of the higher volumes and cost reduction initiatives.

And finally, our power generation segment was affected by the global reduction of commercial construction projects and channel inventory collections particularly in Europe and in the Middle East. Sales decline 35% this quarter versus a year ago and 7% from the first quarter which is normally our weakest quarter of the year. This short decline in sales resulted in an EBIT margin of 6.7% of sales in the quarter compared to the rate of 12.3% in the second quarter of 2008.

For the full year, we are reducing the revenue guidance for the segment to a decline of 30% to 35% as the outlook for the second half of the year shows further softening. We are also reducing EBIT guidance to the range of 7% to 8% of sales for the full year as a result of the short lower volumes and the pricing pressure we discussed on our last call.

For the total company in 2009 as Tim mentioned, we are maintaining our guidance of revenue staying slightly more than 30% and EBIT margins of 5% of sales excluding the restructuring charges.

Now, moving to the cash flow statement, we were pleased with the cash management performance during the second quarter. We generated $238 million of cash from the reduction of inventory which contributed to a net inflow of cash for the quarter of $181 million. All four segments reduced inventory but more notably in the late cycle businesses or five horse per engines, power generation and distribution.

As a result, we were able to fund operations from internal cash flow throughout the quarter without having to access our available credit facilities. The capital ratio at the end of the quarter was 15.9%. Cash management will continue to be a top priority for the Company. For the remainder of the year, we believe we have opportunities to reduce inventory further as we expect the late safer markets will continue to burn off inventory.

We continue to prioritize our capital investments and still anticipates spending $300 million to $350 million this year including capital for flood related damage. In summary, we remain committed to generating positive cash flow in 2009 which will allow us to continue to invest in typical technologies and in profitable growth opportunities.

We will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Meredith Taylor - Barclays Capital.

Meredith Taylor - Barclays Capital

I am hoping you can talk a little bit more about what you saw in the UK and the Middle East in the power gen business. If you could kind of talk about how that evolved over the course of the quarter on a month-to-month basis and then if you could give us a little bit more color on where you think that that channel is right now in the way of reducing inventory and how much there is still is to go?

T. M. (Tim) Solso

Okay, in Middle East and Europe; Middle East was the biggest one. There was quite a very large growth in power gen over the last several years there and the market was one where, there was quite a bit of stocking in the channel because you not only do they mark a lot of goes or a lot of growth but they wanted it on short lead of time. So, we added up significant stocking position in the Middle East and our business demand was just buying that for some time.

Then over the course of the first and second quarter demand fell off, what we said in our remarks was that demand fell out significantly in the second quarter even over the first which is right and then our distribution channel began to react. We did some cancellations and reductions in the demand in the first quarter. We did quite a bit more in the second quarter as a result, our inventory positions in both places are down to much more normal levels.

I will say to you though that still our view is we have more inventory in the channel than demand would suggest today and particularly in the Middle East but we will have that corrected within this quarter as our review, by the time we get done with this quarter, we will be at normal inventory levels is what we expect. But again, our view now is we are in much more, while there is a little bit left to go, we are in much more normalized position feeling much more comfortable for where we are. We took most of the productions in the second quarter that we needed to take.

Meredith Taylor - Barclays Capital

Can you talk a little bit about what kind of price action you saw in the inventory that you reduced? I mean, you did a great job in terms of working the inventory through the system.

T. M. (Tim) Solso

We did not actually do many price reductions on the inventory. As we said in the last call, we were forecasting price reductions of somewhere, on a net basis, somewhere around 1%. So we had some increases at the beginning of the year. Our expectation is we would lose some of those price increases over the course of the year and the net would maybe be 1% down. So, we are not taking significant price actions on a systematic basis.

What we are seeing is in fact, in the market, if price is not being a big lever in most market, there are few places where dealers have extra inventory and they are taking some action on a deal-by-deal basis but so far, price is actually doing okay in the market as a general matter and we are being very, very conservative on price. It did not serve us that well to be aggressive on price in the last downturn. What we did is lower price and demand did not go up and our view is that is still likely to be the case here.

So, really in terms of price, what you can think of is if there is an individual project that looks like lowering price a little bit would make a difference, we might but as a general matter, we are not lowering price.

Meredith Taylor - Barclays Capital

Okay and then just one last quick question and I will pass it along, can you just update us on where you are with respect to backlog in that business?

T. M. (Tim) Solso

Yes, backlog, we are at about a quarters with a backlog. We entered the year at something like nine months of backlog. I am talking about a commercial gen set business. They are not all ancillaries but commercial gen set business which is where backlog mostly exist. We entered the business with a year with about nine months. We are operating that with about three months and that kind of lead time, three months lead time is actually pretty typical when you are not sold out of units. That is not pretty average.

So that is okay. The issue is what will demand do going forward. That is really the question ahead of us. I think backlog is in okay level now. We just need to make sure we continue to see sales flatten out as oppose to drop as you heard from Pat. One of our concerns is that sales will drop a little further in the second half.

Operator

Your next question comes from the line of Chip Miller - JPMorgan.

Chip Miller - JPMorgan

It is Chip Miller for Anne at JPMorgan. Can you provide a little bit more color on some of the other later cycle market as well maybe even on just a relative basis comparing mining, oil and gas, add to power gen and then also any color there on how much backlog you have?

T. M. (Tim) Solso

Yes, in terms of in this quarter, Chip, we saw some continued deterioration in some of the late cycle market. Mining and oil and gas were two that we definitely saw sequential deterioration. As you saw in our outlook and in the presentation, we are still expecting very low level of demand coming from those late cycle markets for the rest of the year. Commercial marine is another one where we have seen especially from a year-over-year perspective, a very weak level of demand, the concerns around credit availability and just the fact that freight tonnage for marine purposes is at low levels as well as commodity prices.

So, I think the cancellations that started to accelerate at the end of the first quarter we have clearly seen run through our high horse power engine facilities in the UK and the US and in India and utilization rates are at significantly lower levels than what we saw coming in to the year.

Patrick (Pat) J. Ward

Chip this is Pat. What I would add to what Tim just said is that we would expect the mining markets now to be down around 40% for the full year and that second half could be half of what the first half earnings were. So, no sign of any improvement in mining for 2009. We will see what 2010 comes in the future. Likewise in oil and gas, we are looking at 30% drop from revenues in 2009 and most of that has already been recognized, most of the revenues already been picked in the first half of the year. So both oil and gas and in mining, second half is going to be tough on the first half.

Chip Miller - JPMorgan

If I could ask on the eliminations line, if I look at the operating profit, it looks like a positive $34 million usually at the negative. Can you just say what drove that?

Patrick (Pat) J. Ward

Yes, we will be happy to assist you on that. As total inventory came down in the quarter with amount of inter company source inventory also came down quite significantly in the quarter and let me walk through a simple example that can illustrate this, Chip. So, when the engine business sales an engine of power generation, the engine business will record that margin at the time of sale. But in [32.15] business, power gen have not been sold at the engine of gen set to an end customer then from a consolidated perspective, it is still in my inventory and I have to back the margin that the engine business reported.

When the power gen does come to sale the gen set including the engine, at that point, both power gen will recognize their margin and I can reverse the inter company margin that I had to eliminate in the previous quarter. So again, so one of the complicated, the basic thought was taking inventory down. We have taken inter company source inventory down and the margins that were tied up in the inter company inventory have also come down quite significantly in the quarter.

Operator

Your next question comes from the line of Stephen E. Volkmann - Jefferies & Company.

Stephen E. Volkmann - Jefferies & Company

A quick follow up maybe to start with on that one, where are we in the process of inventory reduction? Should we expect that corporate eliminations line to be similar in the second half or do we get back to normal sort of in the fourth quarter maybe?

Patrick (Pat) J. Ward

Mostly we do not get specific guidance on elimination. It is included in our 5% guidance and has always been, I think through the first half of the year with no reduced inventory borrowing $280 million and on the last call, Tom mentioned our goal for the year was to reduce inventory by over $200 million that is slightly been presently surprised just we go after that in the second quarter.

We do anticipate as I said in my remarks further opportunity in the second half of the year to reduce inventory but it will not be, we should not expect another $200 million. From looking at our range, I would say range of between $50 million and $100 million in the second half of the year. So the end fact on the eliminations would be much more than what you see in the second quarter just passed.

Stephen E. Volkmann - Jefferies & Company

And then just back with the respect to the power gen business, I mean, is it all kind of Middle East that got a little bit worst than you expected? Does that really explained the change in the forecast or are there other parts of the business that we should be thinking about?

T. M. (Tim) Solso

No, it is not just the Middle East. It is a good question. The Middle East, we were talking about supply chain corrections and I was just talking about where there was a concentration, where we had to bring orders back, cancel orders and we had to get rid of inventory but in fact, power generation markets globally are down and so what has happened is since the beginning of the year, our expectations for the sales in the power generation market have decreased and we decreased them at some in the first quarter and then we decreased them more in the second quarter as we got better use of where we thought the market would be for the year.

So, both the fact that we had to do some inventory and supply chain corrections which reduce sales and absorption since the second quarter happened but also our view of sales for the year also declined across all the market frankly.

Stephen E. Volkmann - Jefferies & Company

Okay so it is broad based. That is great.

Operator

Your next question comes from the line of Jamie Cook - Credit Suisse - North America.

Analyst for Jamie Cook - Credit Suisse - North America

It is actually Jay for Jaime. Quick question, you guys done a very nice job on the distribution side. I know that you touched on the last quarter there is some mixed issues but specifically, is anything really driving that besides for the mix and some of the cost actions that you have had?

Tom Linebarger

Yes, the other thing that we have talked about the distribution business for the last couple of calls is that we have, if the business that we have been growing and expanding into over the last several years, so relatively new business were coming as an owner and as a result, we have been able to improve the performance and cost structure of the businesses as we have grown them. So we now have a larger distributor with more territory. They have better economy of scale and operations and we are as an owner, we are able to find best practices in each distribution location and then move them across.

So, we are just been having better same store performance, if you want to think of it that way across the board as well as to make sure we can focus on good markets in various territories and we can bring whatever capability we need to bear in that territory to capture the market. So, I think just better performance in the business as we have grown and become more capable ourselves in addition to the things you mentioned have improved performance.

Analyst for Jamie Cook - Credit Suisse - North America

Okay, great and then a follow up, in terms of your expectation for the fourth quarter with heavy duty engines, what are you assuming for stock piling?

Tom Linebarger

Not to mean ward, but stock piling, you probably know it is not allowed but as a general matter but we do not exactly know how much our customers intend to use production versus what they need for transition to their new models in 2010. The fact is that given the volatility of the market that they are facing, I think it is tough balance for them as it stands. So, they are all trying to figure that out in sales. What we are responding to is orders. So, we are responding to orders from OEMs and trying to be as nimble as we can because markets as you know are very low. It is down a lot and we are trying to make sure that we are ready to capture whatever order comes our way in order to help our customers both serve current needs as well as transition of models into 2010 and there is a lot of transition too.

They have not only the engine but many of them have new truck models that they are try and transition to and the systems are complicated. So, there is definitely transition work in there but each OEM that they manage, what they are going to do there and we are just trying to make sure we are there to support them.

Patrick (Pat) J. Ward

But as far as pre-buy of the new engine goes or approximately for the regulation takes place, I do not think it is going to be at the same levels that we have seen in previous years. It does not appear to be that way and we have started to see these orders about this time so we do not expect to have the same kind of experiences that we have had where you maximize capacity in the fourth quarter.

Operator

Your next question comes from the line of [Jerry Ravich] - Goldman Sachs.

[Jerry Ravich] - Goldman Sachs

Pat, can you please give us some more detail on the drivers of the 450 basis points sequential margin improvement you are targeting for components? What portion of that do you expect to come from a greater JV income versus cost initiatives that you mentioned and any other pieces?

Patrick (Pat) J. Ward

Yes, most of that will be much coming from JV income. Most of the improvement and components from the first half to the second half is going to come through some recovery and volumes that we talked about earlier on and also from cost reductions and improvement operation efficiency and encouraged by the signs we were seeing towards end of the second quarter and very confident that in the third quarter and the fourth quarter, when we announce this result, you will see the evidence of that.

[Jerry Ravich] - Goldman Sachs

And Pat, what parts of the business is that? Is that the turbo charger piece or is that missions' control? Can you give us some more color on the cost reductions?

Patrick (Pat) J. Ward

My expectations most of the businesses within the segment will continue as it have been doing to focus on taking cost down and that will be something about technology and some with mission solutions infiltration. Our fuel system business is more linked through the heavy duty demand in the engine segments so that is a little bit disconnected but certainly in fuel segments, you should expect to see, I would expect to see improvements and cost reductions significantly in the third and fourth quarter.

[Jerry Ravich] - Goldman Sachs

And Pat, what is your line expense in the quarter and what is your [40.40] assumed for the year?

Patrick (Pat) J. Ward

I think one thing in the second quarter was 4.4%. The sale is somewhat to what it was in Q1 and I would not expect much change in that run rate through the rest of the year.

[Jerry Ravich] - Goldman Sachs

And Tom, based on the joint venture results, it looks like you are seeing some improved power gen demand in China. Can you talk about if you are seeing signs of order recovery in other parts of Asia in recent months, maybe June, July?

Tom Linebarger

Most of what we are seeing so far in China is actually automotive improvement in China. We are seeing a DC-DC joint venture starting to see some up tick in demand. I have already seen some up tick in demand which will be for trucks. We also see some, we have also bus demand and we are beginning to see signs of construction as well because there is the stimulus work in China started earlier and they have got more of the dollars out so there is actually stimulus stuff going that is driving again bus and construction.

But automotive is the biggest single lever for us in China both because that is the market that is improving the quickest and that is where we have the largest piece of our business in China today.

[Jerry Ravich] - Goldman Sachs

And Tom what about for the power gen outlook for China, what are you seeing there? Have you seen orders started that come back?

Tom Linebarger

Not yet, I mean it is not that within for us far so there was less negative impact. There is not the same sign at least that we have seen that the power gen markets are recovering in a significant way in China though I would not be surprised to see them a couple of quarters later start to also see some recovery because essentially in China, we are just seeing the recovery starting and power gen will be a little later cycle like we have in the automobile orders. So, I would not be surprised to see it but we have not seen it yet.

Operator

Your next question comes from the line of Andy Casey - Wells Fargo Securities.

Andy Casey - Wells Fargo Securities

First question, I guess if we can go back to the power gen, are you seeing any inventory liquidation at this point from the rental companies?

Tom Linebarger

Andy, nothing that I can speak to. It is not a subject that is up to date, it should be on but I have not, there is nothing that I know about in that regard.

Andy Casey - Wells Fargo Securities

And then on the, it was better than expected, but on the heavy duty truck line, I am trying to understand the revenue performance in the quarter. Did you realize any pricing or improvement in part sales or gain in market share relative to what you had in the first quarter?

Tom Linebarger

No, not really.

Andy Casey - Wells Fargo Securities

Okay.

Tom Linebarger

Tell me more, tell me what numbers you are looking at that seem unusually good to you.

Andy Casey - Wells Fargo Securities

Well, if I tie it to what I assume in the breakdown of that, the North American unit production went down sequentially but your revenues stayed basically flat.

Patrick (Pat) J. Ward

Yes, I think the one item that could cause some of that would be market share and market share at the end of May, we were close to 50% and I think in the June, we also got it closed to 50%. So, it is up definitely a couple of points from the first quarter but there will be no pricing and I have lengthened this with any thoughts mix change rather with regards to that sigma.

T. M. (Tim) Solso

I think probably Andy, there is probably maybe 500 units more Q2 to Q1 in North American heavy duty truck so I think it is more reflection of as we indicated that it is not pricing, it is market share penetration.

Operator

Your next question comes from the line of Charlie Rentschler - Wall Street Access.

Charlie Rentschler - Wall Street Access

I got confused by the four new engine platforms that Tim said would be launched next year and then Tim, you went on to talk about heavy duty and I think then Tom pitched in 3.8 to 2.8 but I did not hear what the fourth engine was or maybe I was not paying attention.

T. M. (Tim) Solso

Yes, the 2.8 to 3.8 and 11.9 in the 13 liter.

Charlie Rentschler - Wall Street Access

Okay, there we go and Tim, can you update us on your thoughts on Nova Starr's plan to launch heavy duty EGR engines next year?

T. M. (Tim) Solso

Yes, we still have a fundamental difference of opinion on which technology is the best. We have a long standing close relationship with Nova Starr and we continue to have that both with management levels as well as between our distributors and their dealers. We are about 85% of their bill right now and we continue to discuss future opportunities but the disagreement between SCR and EGR remains.

Charlie Rentschler - Wall Street Access

Okay and just as a final question, if you look at the world, how would you rank the best behaving markets? Would China and India at the top and then going on down are, what is your latest..?

T. M. (Tim) Solso

I would think that in terms of, as Tom said and I want to be really careful about this is that we are seeing a heartbeat in China and India, okay. It is not a full pledge recovery and we are also seeing some good activity in Brazil so when we talk to you 90 days from now, we will be able to say more about those markets but clearly in India, well in all three countries, the stimulus activities by their governments has been at least reasonably effective so far and we will see those markets, I think at least in our plans right now that would be followed by North America and Europe would be left.

Operator

Your next question comes from the line of Joel Tiss - Buckingham Research.

Joel Tiss - Buckingham Research

On the components business, do you think, do you expect to see a little bit of a ramp in the second half of 2009 and into early 2010 just from having higher content on the new emissions engines?

Tom Linebarger

Yes, but again mostly of course in 2010, not in 2009 but yes, in 2010, we will have higher content and that will help our revenue especially in the emission solutions business, both in some degree in turbo two. The question will be the volume and right now, we have not done our 2010 plan now but the expectation is that volumes will drop in the automotive, the heavy duty truck and mid range truck market after the first of the year, at least in the first half it will drop some and then our hope is to recover after that. We do not know for sure yet because as Tim says, the pre buy is unclear and not likely to be huge but that is the part we do not know is the overall volume but we do expect higher content on the engines that we shipped in 2010.

Joel Tiss - Buckingham Research

And that is all margin accretive, all those mix pieces you have given us together?

Tom Linebarger

It is margin accretive, right. What you are asking is, are we selling those emissions bucks for more than cautious to make them, yes, we are. That is our intent. Is that what you are asking?

Joel Tiss - Buckingham Research

No, it is just you gave us like three different pieces. This will be stronger. This will be weaker and when you put all those together, do you think we will start to see more respect in the margins at that component.

Tom Linebarger

I understand your question better now, Joel. The answer is I do not know yet. I mean the answer is I have to put together my 2010 plan because the volume impact versus the price and cost impact is just not clear too. I got a better hand on the volume because the volume, all three will be relevant to whether it ends up being margin accretive or not in total. I just do not know the answer yet.

Joel Tiss - Buckingham Research

Okay.

Tom Linebarger

I mean long term, it definitely will be. The question is I think for first half of 2010 is what I do not know yet.

Joel Tiss - Buckingham Research

Okay and then in the engine business, I do not know if Andy was asking about this before but the market share is up only 2 points and it seems like your percentage point gain has been running a lot higher than that since that got out of the business. Is there some change going on there or is it just, I do not know, seasonality or something else?

T. M. (Tim) Solso

It was 2% over the second quarter over the first quarter. If you go back last year, the market share is up 5 points.

Joel Tiss - Buckingham Research

Okay, so it is still pretty consistent and you are still sticking with the 35% plus or minus as we round into 2010?

T. M. (Tim) Solso

Yes.

Operator

Your next question comes from the line of Henry Kirn - UBS.

Henry Kirn - UBS

I am wondering if you could talk a little about the health of the end user balance sheet across your business given that we are a little further now into the downturn.

Tom Linebarger

Yes, are you saying in a trucking company specifically or wider look, Henry?

Henry Kirn - UBS

Trucking companies but then also the power gen end-user stat as well.

Tom Linebarger

Yes, okay so let me start with trucking companies. Both Tim and I have visited a number of customers and they are definitely hurting. There is a closer range, you have got small trucking companies which are suffering quite badly and then you got bigger fleets who have more financial strength but all are having a really rough go and a lot of what Tim talked about with regard how big the pre buy is partially affected by confidence in our engine is why do they need to pre buy but a lot have also is that they just do not have money. I meaning buying is a really tough trade cycle now because people do not have much money to buy. So balance sheets are definitely, I mean it is a tough time buying capital equipments. It is difficult and that is why you are seeing such low truck purchasing activity and the other added part of it is used trucks markets week so they can trade all once away.

So, for the truck companies, which is what they are trying to deal with both with their customers cannot trade out their old one and they do not have much money to buy new ones. I think that is probably straight forward point given where the economy is but their balance sheets are generally weak.

In the power gen market, it is a very different dynamic that you are looking at because end users of power gen equipment are typically somebody building a building or constructing a sewage treatment plan. So, now there is really no general statements you can make. You are talking about serving really all sectors of the economy and it is really building markets. The question is who is building new buildings or upgrading new buildings or etc and that is why you see sectors that are tied in non risk construction so it is when people are active and that is why it is a late cycle fall and it is also going to be a late cycle recovery because it is tied to non risk spending mostly.

T. M. (Tim) Solso

And I would add that both in construction and in automotive truck, some of the dealers have gone under and there has been some consolidation there if you go to some of the consumer markets, both companies cannot get credit. They are basically out of production right now and I would say there are several there, also the marine dealers are hurting right now. Same thing with ERVs. We have seen some bankruptcies there. Again, the dealers had some issues so across the board, there are some fall out and I would say generally, credit is either not available or available on a very limited basis.

Tom Linebarger

Henry, you did not asked but just because it is related, you probably know that we are also working very closely with our supply base and particularly that part of the supply base is also supply the car industry and they are also financial health is a really important focus for us. We got a very in-depth effort on that. We have been working on that for more than a year now. We have people very closely focused on making sure our supply base, the critical part that remain healthy on a long standing basis but that is also concern of ours with regard to financial health.

Henry Kirn - UBS

That actually addressed my follow up. So, one other thing, globally as you look at your top competition, are there any opportunities from competitors who maybe catering a little bit?

Tom Linebarger

The answer is we are definitely on the look out for any such opportunities. Well, I think it is unhealthy and unwise to predict the failure of any competitor. I do think that we are of the view as we said during our remarks. We think we are well positioned. We think we are financially well positioned. We think we are managing really well and our opportunity here is to demonstrate that we care about our customers even when things are tough so that when things get better, we build customer loyalty and we are there to serve them in. We are going to do that irrespective of who is around to compete with us but we will be looking for opportunities as they arise.

T. M. (Tim) Solso

I would just add that you should not underestimate the fact that we are bringing out more product in 2010 and the various tiers and components associated with that more than we have ever done as a company and assuming we perform well in those launches and the products perform well, I think we will have a significant opportunity versus our competition and a significant opportunity for growth and we have kind of talked about that and we are now entering into getting very close to launching these products and Tom and the operating people are paying a lot of attention to that and the results that we are seeing from our prototypes are test and so forth are very positive right now so I think in looking at common clearly into 2010 and the 2011 are product launches and the amount that we are doing is a significant opportunity.

Operator

Your next question comes from the line of Ben Elias - Sterne, Agee & Leach.

Ben Elias - Sterne, Agee & Leach

I have a question. Historically, you have given us great detail on the EBIT bridge and I have seen that and if I just compare what we saw in February and on the change in April especially with FX where FX went from being a headwind to tailwind and since then, we have seen the dollar weakened further. I was wondering what the sensitivity on that and if anything else has changed on that EBIT bridge especially the other thing was the prior material input cost that again swung on your saver so I was just wondering about that and also on the engine side for competitor who does not have an engine ready, how long is that transition period and people have mentioned a special agreement with a supplier. I was just wondering about your production rate and your contingency planning for additional manufacturing over the back half of the year.

Patrick (Pat) J. Ward

Well I will take the first part of the question and maybe Tom will jump in the second part. On the EBIT bridge year over year, it is not definite from what we talked about on the last couple of call. So, we are going to be doing first the four percentage points from 2008. Volume is clearly the largest driver of that. We are seeing negative joint venture income of seven tensile of point year over year which is consistent with what we said before and they will be offset by placing and cost reduction.

So the bridge I talked about back in April is exactly the same bridge at the higher level that we are looking at today. If you got specific questions on Q2 to Q2, I am happy to follow up with actually year over year picture. With regards to foreign exchange, in the second quarter, it costs us about $150 million of revenue which was both 4% of total but had very little impact of the bottom line.

So, FX is not really a major factor from profitability perspective quarter over quarter or year over year and then on material cost, the question you asked for material cost, it is moving around a little bit but I think the story remains the same that the first half of 2009 will be better. It has been better for the second half of 2008 but it is still higher in what the first half of 2008 was. Now, what you will expect to see for the Company, further improvement in the second half of 2009. So, we are seeing four consecutive quarters last year of a headwind on material cost than commodity cost and we are starting to see in the first two quarters of this year that coming back and we expect to do some more improvement in the second half of the year.

I do not think we are going to get all the way back to where we started off at the beginning of 2008 but we have made significant progress in getting back towards that point.

Tom Linebarger

Ben, sorry, Pat talked is long. Could you just remind me what your question was again? Was it about transition?

Ben Elias - Sterne, Agee & Leach

Sure. I was just wondering about competitive coming out on engine, any other stuff and if that engine is delayed, what are the contingency plans if they require more engines, how long is that transition period and what does it do to production and manufacturing rates?

Tom Linebarger

First of all, with regard to their engine, we are not really pretty detailed what their plans on delays or on time mark. There is, as you said, some speculation about it but I think it is speculation. I do not and I certainly cannot comment on. They are the best to comment on that and with regard to transitions, if our customers are not ready with their engine or their truck, as I mentioned, each of them is going to manage that in their way. They need to be the ones who figure out which trucks are ready and which engines they are going to use and they place orders on us for engines that they need both in current production today and for their transition period and we will respond to orders as such and comply.

There is one significant complication is that we will be providing engines for 2010 that are actually with FCR. So whoever we are showing engines to, w need to be able to integrate an FCR system into their truck. That is what we have been spending the last most of this year are making sure that works flawlessly and customers take good reliability and performance and that is what providing the fuel economy advantage for our customers in 2010.

So that is one complication that every truck may go we will have to deal with which is they have the engineer FCR on and as you know in that case, they are not claimed. They will offer FCR in 2010 so that is just one thing to deal with. But I really think in terms of what their backup plans are, I am going to stop. You better ask them.

Operator

You have a follow up question from the line of Stephen E. Volkmann - Jefferies & Company.

Stephen E. Volkmann - Jefferies & Company

I just wanted to follow up on a couple of things quickly. First of all, do you guys, are you seeing an order book building at all for your fourth quarter truck engine business in the US?

Tom Linebarger

The answer is order book, no. indications that people may want to increase orders in the fourth quarter somewhat begin with Tim's caveat there is not going to be a big pre buy that there will be some increase yet. The hands are forecast.

Stephen E. Volkmann - Jefferies & Company

Okay so you still have, I am assuming, plenty of delivery slots for the fourth quarter available?

Tom Linebarger

That would be correct?

Stephen E. Volkmann - Jefferies & Company

And then just on this whole Nova Starr thing, I guess just to be clear here, is your understanding of the regulations that Nova Starr will not be able to purchase a meaningful number of your current 15 liter engine in the fourth quarter to tie them over in 2010?

Tom Linebarger

My understanding of the regulation is again just, as you guessed with any regulation is complicated and you have to read it but let me just say this simply. What the regulation provides for is that manufacturers still have a reasonable opportunity to transition between one year in the other. That is basically what is allowed for and that is what all these OEMs are responding to is reasonable transition. The reps I think is at a level of detail interpretation that really you ought to take a look to yourself and it would be this year and dumb of me to summarize in any way that I interpret it.

But here is what I would say is that each of them has had a transition plan and that has been the case for every single emissions change that there has been 2007, 2002, etc and that is what everybody is doing and so if we go back to the previous question, I think the best way to figure out what Nova Starr's plan is in terms of transition is ask them because it is just not our, we are not in charge of figuring it out and we just cannot it out because they are pretty, they are managing it as they go. They are not all set in stone. They are all trying to figure out what to do given market conditions that are out there.

Stephen E. Volkmann - Jefferies & Company

Fair enough, okay. I was just trying to make sure. I am sure you guys understand the rights better than I do so that is kind of what I was looking for.

Tom Linebarger

No, it is a fair question, Steve. It is just plot with difficulty within the regulations. You have to read it to…

T. M. (Tim) Solso

It is not precise as Tom is saying. There is ambiguity. There is, so people can use judgment.

Stephen E. Volkmann - Jefferies & Company

Yes, I guess the definition of the transition period probably sounds like the key issue. Can I just switch for a second? My understanding on your component business is that you guys had been working through some changes in your supply agreements with other people with your contracts and so forth that would hopefully help you a little bit on the margin front as we move into 2010 and beyond, am I right about that? Can you give us a quick update there and how that is going?

Tom Linebarger

I think what you should take away, Steve, is I think we have got some design related work and programs that we think we can get material cost improvements. I would not, when Pat was giving you the bridge earlier about component stability to deliver 400 or so basis points more in the second half, that has a lot to do obviously with the volume ticked up that we expect in the second half and some of those businesses and the other part being on commodity cost, not from beating up suppliers but really some really good work that we are doing to manage the material commodity cost content in our own product.

Stephen E. Volkmann - Jefferies & Company

Okay and I guess, I was sorry, I was not clear about that. I was thinking more about 2010 as you sell components to other manufacturers. I assume you will have new agreements and new contracts with them and my understanding was that the pricing, the base pricing, would be a little more favorable in 2010 as you did that transition.

Tom Linebarger

Steve, you have that right. That is exactly we said last time that is right. So, we are definitely, we negotiated with 2010. We have more content as one of the previous callers asked and we have done this cost reduction that both Pat and Tim talked about. Those are all elements to how we drive towards our target profitability as volumes improve is that we have a good contract for the customers, good costs and then we begin to get volumes back. That is exactly what will take us to our target profitability levels. You are right. That is the significant element.

T. M. (Tim) Solso

Both ignition solutions and turbo chargers have moved towards long term agreements with the OEMs effective in 2010 and going beyond and that is where the pricing would come in.

Stephen E. Volkmann - Jefferies & Company

And I guess the point is you are getting that pricing as those contracts are renewed, if there has not been pushed back or anything on that.

Tom Linebarger

Plenty of push back.

T. M. (Tim) Solso

But we are given the result, yes.

Dean Cantrell

I think that is all the time we have for questions today. I appreciate everyone's attendance and I look forward to talking with you again in the next quarter earnings call. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a wonderful day.

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Source: Cummins, Inc. Q2 2009 Earnings Call Transcript
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